JP Morgan CEO Jamie Dimon’s recent commentary in the Washington Post proclaims that financial institutions need to be able to fail. He also describes the need for regulatory changes that would enable this to happen while minimizing the effects should a firm do so. What he does not describe is why firms need to be able to fail. Judging from the comments out there, it’s clear there’s a need to understand the why. It is central to understanding what regulatory changes, if any, are even required.

Mr. Dimon is correct for one simple reason: When there is the perception of risk with a trading counterparty, risk management will arise to deal with that risk. Due diligence with regards to understanding the counterparty will increase in proportion to the perceived risk. In the extreme case, risk management may dictate that the trading (however simple or complex) may not take place at all. Note that “trading” in this case is not simply what everyone envisions on some Wall Street trading floor, but the very essence of any transaction between two individuals.

The absence of “too big to fail”, and the extra due diligence that would have instead been present, would likely have prevented the entire housing-related financial debacle we’re all living through, including the current hand-wringing about what to do about it.

When a firm is deemed “to big to fail”, anyone trading with that firm is afforded the luxury (or trap) of letting their risk management guard down. “Hey, my counterparty’s existence is a sure thing — why should I care what they’re doing behind my back? — It can’t affect me.” The story of the Norwegian town of Narvik illustrates this perfectly.

With truly free trade, two potential trading partners, X and Y, will only trade if they make each other better off. To do that, they must know each other’s needs. Say X and Y are contemplating a transaction, but X is deemed “too big to fail” by some trusted third party — ie, 100% trustworthy in their ability to fulfill their obligation to Y, and/or of their ongoing existence. Trading partner Y now has far less need to understand trading partner X. In some ways, rather than Y needing to exhibit reciprocity in its care for its trading partner, it can act more selfishly, focusing more so on its own gains. Knowing that X’s continuation is a sure thing, Y might not even feel entirely obligated to honor their obligation to X — “If I don’t, what difference will it make to them?” This, combined with lax bankruptcy penalties, might have been all that was needed to prompt some people to stop paying their mortgages as their houses went “upside down”.

Amongst the chain of players in the housing market, note the prominent role of Fannie Mae and Freddie Mac, two institutions that were generally thought of as “too big to fail”. Any mortgage originator who could raise product in a way that could conform to Fannie or Freddie’s securitization requirements could lay off whatever risk they initially had to these organizations. They were therefore incentivized to raise as much product as they could, earning commissions and short term compensation along the way, knowing that anything Fannie or Freddie did downstream was irrelevant. Loans to borrowers with sketchy credit profiles? No problem! Sell ’em off to Fannie or Freddie! This is exactly what occurred with firms such as Countrywide Financial.

Suppose that Fannie and Freddie did not have their implicit government guarantee, or political pressure to assist in expanding home ownership. They would then have been far more concerned with the quality of the collateral they were purchasing. This would have rippled all the way back to the origination of the loans, because the resulting loans would have been less marketable, and in many cases, perhaps not marketable at all.

However, there would have still been a role for risk-takers to provide a valuable service to the market, in the form of making higher interest loans (to compensate for the risk) to higher-risk borrowers, and NOT selling the loans to a third party. But there would have been an important difference. It would be the free market and private decision making, as opposed to a political process, determining where on the risk-reward curve the business activity would be.

Mr. Dimon also does not mention the massive instructional benefit of failure. While failure in and of itself is generally not pleasant to watch (perhaps with this exception), it is invaluable as a teaching tool. It allows all non-participants to learn in a way that is every bit as valid as those who did participate: Watching someone burn himself on a hot stove doesn’t require me to touch the stove as well to learn not to touch it. Simply knowing that people can burn themselves on hot stoves is enough to make me cautious and treat the stove with respect. This country needed to witness failure of lending to unqualified people to ensure that such poor business practices did not expand in scope. Failure of unqualified borrowers to obtain credit is not evidence of a broken free-market. It’s direct evidence of the market working!

If failure were permitted to happen in an unhampered fashion, private defense against possible failure of trading counterparties would necessarily increase. There would be no need for a regulatory agency to try to outthink the market as a whole (an impossibility, yet one that many people sadly think is possible), because out of their own self-interest in self-preservation, companies would do it themselves. Even still, there may be opportunities for private firms to arise that would add additional risk-management services in the form of wider information visibility and/or better analysis. There is simply no need to politicize the function. Claims that companies self-policing themselves have failed ring hollow because the necessary punishment of true corporate failure was not present.

A politicized version of the crucial risk-management function produces things like forcing a bunch of firms to take TARP money, even those who don’t need it, to shelter the identity of those who do. Discovering these weakened firms faster and more unambiguously is exactly the kind of information that market participants (companies AND individuals) need to correctly perform their risk assessment. Simply the threat of being put on such a list would be enough to keep an honest company concerned with the best interests of its customers off the list.

And this is exactly where we’d wind up. Financial stability, security and trustworthiness would rapidly become the aspects that financial service companies would compete over. Large financial institutions would have to prove to their customers that they are conducting themselves in ways that make their customers comfortable in trading with them, lest they watch these customers go elsewhere. Not with some phony “too big to fail” claim, backed up with a politicized redistribution of private wealth, but with honest and verifiable proof using their own resources. It’s already started, with small and regional banks running ad campaigns highlighting the fact that they didn’t take TARP money. It’s a trend we need to encourage.